Inside Experts: Creating good business contracts

Recently I negotiated a software hosting contract with a customer on the West Coast. The contract, a template that I wrote for the hosting service, has a liquidated damages clause. I set the amount of the damages based on several factors including reprovisioning data center resources to another customer.

In the negotiation call, the customer asked me several times over if the damages clause was all that he would owe if he stopped paying us for the service mid-contract. I replied yes, that the purpose of liquidated damages is to settle up without having to go to court. Then the customer showed his hand. He wanted to negotiate a right to terminate for convenience. The damages clause in the contract wasn’t really much different than termination for convenience, the customer argued, because the clause allowed him to get out of the contract for a fee he considered inexpensive relative to the contract’s multiyear term. I responded no, that by signing the contract, he was taking on a legal obligation to purchase the service in its entirety.

In the end, I counteroffered (I won’t say what) and the customer signed. Afterwards, the account executive told me the customer had wanted termination convenience outright because he just wasn’t comfortable with the stigma of breaking a contract.

What the customer was arguing for, though I’m certain he didn’t know it, can be found in Richard Posner’s theory of law and economics and is known by legal scholars as “efficient breach” of contract. Posner’s theory states that it is better for a party to breach a contract and pay a settlement fee if doing so leads to higher productivity. Parties keeping their contractual promises out of a sense of moral duty, without regard for the business consequences, can be counterproductive. It would be more efficient in Posner’s view for my hosting customer to declare his intent to end the contract and pay the liquidated damages, presumably freeing both of us to pursue better business opportunities.

I’ve made another on-the-job observation about contracts. I am in an ongoing debate with several account executives about putting start dates in agreements for consulting projects. I tell them that without a time of performance, the agreements are incomplete. I could let them add a start date later by amendment, or leave a blank for the date to be filled in just before signature, but I’m not certain that either would end up getting done. The account executives tell me it is impossible to know exactly when the work will start. They have many reasons for this, from the contract getting delayed in the customer’s approval process to the customer going on vacation. What the account executives really want to avoid is forcing the customer to make a commitment. The account executives aren’t so much concerned about having an enforceable contract as they are with maintaining a relationship with the customer that will lead to more business. At the same time, they want to get some kind of agreement in place and get the deal “off the street.”

The position taken by the account executives isn’t exactly wrong. Their position recognizes the need for what the late law professor Ian MacNeil coined a “relational contract.” Contracts work like a photograph, fixing terms at a point in time. But business dealings, especially in our modern services economy, are hardly ever static. Things change, including start dates. The trick is to come up with binding contracts that don’t get in the way of the parties successfully working together. I have reached a compromise with the account executives by allowing them to use the phrase “on or before” and picking a specific date in the future, which allows for flexibility while still providing a time of performance.

To summarize, I have observed the following:

Business people understand that not making good on commitments looks bad

Business people place more importance on relationships than they do on legal obligations

Business people demand the ability to deal with change and uncertainty with the fewest possible constraints

What do I conclude from these observations that will help me and other in-house counsel with business contracts?

Good business contracts should be more basic in their terms and shorter in duration than they have in the past. Instead of trying to cover every contingency, terms and conditions should focus on the essentials: exchange of consideration, price, time of performance/delivery, payment, and governing laws and regulations. Descriptions of products and services should be as compact as possible, with details to be added later as they develop. Good business contracts also should include processes for how parties will deal with each other. A point person should be named for each party to document specifics, make changes and resolve problems. For larger and longer business transactions such as outsourcing and joint marketing, contracts should be modular, allowing parties to bite off and digest smaller pieces of business. By making contracts easier to enter into and by covering only what is visible on the horizon, companies can do business more effectively and with less friction.

In-house counsel also need to look at the way their contracts are produced. Instead of trying to negotiate every clause in every transaction, counsel should measure and manage the amount of time and resources they put into contracts. This does not mean outsourcing the company’s contracts to India. It means mapping the contracting function from cradle-to-grave and making adjustments. More responsibility for contracting should shift from the legal department to the business side, but not without first developing the necessary internal competency on the business side to work with the legal department, and then always subject to final legal review. Most likely, in-house counsel will find that their contribution or “value add” isn’t all up front in the process, and that it is impossible for them to add value by working in isolation.

While I believe in-house counsel need to redefine what makes a good business contract, having a complete and definitive written contract isn’t any less important than it ever was. Sound business relationships are based on trust. Trust in turn is earned by making commitments, putting them in writing, and keeping them.